Euro's Future
NOT SURE WHAT TO DO WHEN THE TREND COLLAPSES-LEARN HOW HERE
The past week has seen a shift in the outlook for the euro. Not that long ago people thought that if the EU summit delivered more than the market expected and took steps to stabilise Italy and Spain’s financial predicaments then the euro could rally following a reduction in credit risk in the region. However, that did not happen. Instead, in the week after the end of the EU summit the euro is 2.5% lower against the dollar and 2% lower on a trade-weighted basis. Added to that Spanish and Italian bond yields have risen sharply since the start of the week and at the time of writing Spanish yields were flirting with the 7% level that is considered bailout territory.
So why the sell-off in the single currency? We don’t necessarily think it is because the markets were disappointed by the EU summit. In fact, the summit delivered more than the market generally expected included steps towards banking union, more flexibility for the ESM/ EFSF rescue funds and also the EU may scrap seniority clauses in its bailout loans to Spain’s banks. Although we need more detail, especially on the extension of the ESM/ EFSF rescue funds, this delivered more structural change (although no more money) than we have seen at any of the 18 other emergency EU summits.
Instead we argue that the sell-off in euro-based markets was down to two factors: 1, the ECB not offering a stronger tonic than rate cuts at its meeting on Thursday and 2, some bickering among EU politicians, especially those in the Northern Bloc, who don’t like the idea of extending the powers of the EFSF/ ESM and are also against scrapping the seniority clause in Spanish bailout loans.
The ECB met on Thursday and cut interest rates by 25 basis points to 0.75% (a euro-era record low). It also cut the interest rate that it pays to banks that leave money with the ECB to 0% in an effort to boost lending in the wider economy. However, this may not work. Europe’s banks have been parking large amounts of cash with the ECB and by cutting the interest rate they earn to zero it actually erodes their profitability. Added to that, in an era of austerity there is no guarantee that the banks will either want to lend, especially to riskier customers, or that there will be demand for loans when the growth outlook is so bleak and unemployment in the region reached a euro-era record of 11.1% in May.
The ECB failed to announce, or even hint, that it would adopt more unorthodox measures to try and stem this crisis. There was no mention of LTRO 3, no sign of QE or a resumption of the SMP bond-buying programme. Essentially the markets want the ECB to act as a bridge from where we are today (a dysfunctional union with a major credit imbalance problem) to where we want to be in the future – the land of fiscal union. That will take time and the politicians need to hash out the details, which could take months, therefore, the markets had expected some more radical action from the ECB last week. We do think that eventually the ECB will re-start its SMP programme if Eurozone bond yields move even higher, however, because it failed to do so on Thursday this added to the upward pressure on Spanish and Italian bond yields at the end of last week.
We also mentioned that bickering by politicians could hurt sentiment. The German finance minister was speaking on Friday and said there can be no aid to Eurozone members without conditionality, which threw into doubt the summit “breakthrough” that the EFSF/ESM rescue funds, could re-capitalise banks or buy sovereign debt without having to impose strict austerity programmes. Thus, there will be no money for nothing from Europe’s strongest economies.
So how does this impact the euro? The euro tends to fall when credit risk rises, hence EURUSD has declined along with the rise in Spanish and Italian bond yields. Added to that the ECB didn’t take any measures to reduce credit risk in the currency bloc, at least not in the short-term, and instead made some drastic cuts to interest rates. This eroded the euro’s yield differential, and since yield is a key driver of FX, we believe these rate cuts signal a lower euro for the short-to-medium term.
The 2-year Eonia swap rate (which is used to price the value of the euro in the swaps market) fell sharply on the news, and that seems to be one of the key drivers of weakness in the single currency. The rate differential between Germany (as Euro-area benchmark) and UK Gilt yields has narrowed sharply since yesterday as the ECB and credit risk in the periphery drive safe haven flows into Bunds. This is weighing on EURGBP. 0.7980 had been a major support level; since this has been broken we are looking at fresh multi-year lows for this pair potentially towards 0.7750 in the short-term.
The rate differential between Germany and the US is also euro negative, and since we expect the Federal Reserve to remain on hold when it meets in late July/ early August we believe EURUSD losses could be extended. 1.2280 is the next major support level, which is the low from early June. Below here opens the way to 1.20 – the April 2010 lows. Short euro positions are already stretched, so the decline may not be even, thus, we could see some pullbacks along the way, especially if the Fed is particularly dovish in the coming weeks. 1.2450 is key resistance ahead of 1.2620.
Read More at Forex.com
TRADE WITH THE BEST TRADERS IN FOREX AT FMP
The past week has seen a shift in the outlook for the euro. Not that long ago people thought that if the EU summit delivered more than the market expected and took steps to stabilise Italy and Spain’s financial predicaments then the euro could rally following a reduction in credit risk in the region. However, that did not happen. Instead, in the week after the end of the EU summit the euro is 2.5% lower against the dollar and 2% lower on a trade-weighted basis. Added to that Spanish and Italian bond yields have risen sharply since the start of the week and at the time of writing Spanish yields were flirting with the 7% level that is considered bailout territory.
So why the sell-off in the single currency? We don’t necessarily think it is because the markets were disappointed by the EU summit. In fact, the summit delivered more than the market generally expected included steps towards banking union, more flexibility for the ESM/ EFSF rescue funds and also the EU may scrap seniority clauses in its bailout loans to Spain’s banks. Although we need more detail, especially on the extension of the ESM/ EFSF rescue funds, this delivered more structural change (although no more money) than we have seen at any of the 18 other emergency EU summits.
Instead we argue that the sell-off in euro-based markets was down to two factors: 1, the ECB not offering a stronger tonic than rate cuts at its meeting on Thursday and 2, some bickering among EU politicians, especially those in the Northern Bloc, who don’t like the idea of extending the powers of the EFSF/ ESM and are also against scrapping the seniority clause in Spanish bailout loans.
The ECB met on Thursday and cut interest rates by 25 basis points to 0.75% (a euro-era record low). It also cut the interest rate that it pays to banks that leave money with the ECB to 0% in an effort to boost lending in the wider economy. However, this may not work. Europe’s banks have been parking large amounts of cash with the ECB and by cutting the interest rate they earn to zero it actually erodes their profitability. Added to that, in an era of austerity there is no guarantee that the banks will either want to lend, especially to riskier customers, or that there will be demand for loans when the growth outlook is so bleak and unemployment in the region reached a euro-era record of 11.1% in May.
The ECB failed to announce, or even hint, that it would adopt more unorthodox measures to try and stem this crisis. There was no mention of LTRO 3, no sign of QE or a resumption of the SMP bond-buying programme. Essentially the markets want the ECB to act as a bridge from where we are today (a dysfunctional union with a major credit imbalance problem) to where we want to be in the future – the land of fiscal union. That will take time and the politicians need to hash out the details, which could take months, therefore, the markets had expected some more radical action from the ECB last week. We do think that eventually the ECB will re-start its SMP programme if Eurozone bond yields move even higher, however, because it failed to do so on Thursday this added to the upward pressure on Spanish and Italian bond yields at the end of last week.
We also mentioned that bickering by politicians could hurt sentiment. The German finance minister was speaking on Friday and said there can be no aid to Eurozone members without conditionality, which threw into doubt the summit “breakthrough” that the EFSF/ESM rescue funds, could re-capitalise banks or buy sovereign debt without having to impose strict austerity programmes. Thus, there will be no money for nothing from Europe’s strongest economies.
So how does this impact the euro? The euro tends to fall when credit risk rises, hence EURUSD has declined along with the rise in Spanish and Italian bond yields. Added to that the ECB didn’t take any measures to reduce credit risk in the currency bloc, at least not in the short-term, and instead made some drastic cuts to interest rates. This eroded the euro’s yield differential, and since yield is a key driver of FX, we believe these rate cuts signal a lower euro for the short-to-medium term.
The 2-year Eonia swap rate (which is used to price the value of the euro in the swaps market) fell sharply on the news, and that seems to be one of the key drivers of weakness in the single currency. The rate differential between Germany (as Euro-area benchmark) and UK Gilt yields has narrowed sharply since yesterday as the ECB and credit risk in the periphery drive safe haven flows into Bunds. This is weighing on EURGBP. 0.7980 had been a major support level; since this has been broken we are looking at fresh multi-year lows for this pair potentially towards 0.7750 in the short-term.
The rate differential between Germany and the US is also euro negative, and since we expect the Federal Reserve to remain on hold when it meets in late July/ early August we believe EURUSD losses could be extended. 1.2280 is the next major support level, which is the low from early June. Below here opens the way to 1.20 – the April 2010 lows. Short euro positions are already stretched, so the decline may not be even, thus, we could see some pullbacks along the way, especially if the Fed is particularly dovish in the coming weeks. 1.2450 is key resistance ahead of 1.2620.
Read More at Forex.com
TRADE WITH THE BEST TRADERS IN FOREX AT FMP
Comments